Liquidity in corporate credit declined significantly as 2015 progressed. Turnover dropped, transaction costs spiked, and a number of credit funds folded.
Far worse than that, at least from a systemic point of view, is the growing gap between the liquidity offered to investors in credit mutual funds and the actual liquidity in the underlying bonds.
Changing regulations have reduced banks’ repo activities, which have fallen from peak levels of over $4.5 trillion in late 2007 to below $2.5 trillion today. As a result, investors looking for safe opportunities to park cash short-term have been forced to look for alternatives to the repo market, and this is where credit mutual funds enter the frame. Because banks offer daily liquidity on these types of products, they are increasingly used as an alternative to repos, regardless of the questionable underlying liquidity.
Credit spreads could widen significantly as a result, and mutual fund investors could face long lock-ups. Economist, Niels Jensen asks whether this could spread to equities. “It certainly did in 2008, although hardly anyone expected it to do so at first, when Bear Stearns’ two credit funds blew up in the summer of 2007 (although the world is now full of people who claim they did). For this reason, I don’t expect it to happen this time (in a major way).”
He adds, “Crises almost always happen as a result of excessive optimism and not when scepticism runs deep – as it does at the moment. Equities had a rather difficult time in the second half of 2015, partly because of the problems in the credit markets. In other words, it would be entirely wrong to postulate that equity investors have so far ignored the brewing liquidity crisis in credit.”
Illiquid stocks, which typically have better returns than the overall market, in reality are still fairly liquid. But trying to sell distressed debt or other extremely illiquid assets is much more difficult. And, in any case, “things that are really illiquid do not belong in mutual funds,” maintains Roger Ibbotson, the Yale School of Management professor emeritus and chairman of Zebra Capital Management.